A Not So Gentle Reminder Of Why You Should Own Bonds

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Includes: AGG, BHK, BND, BNDS, BOND, BTZ, DBL, EGF, FBND, FTT, GBF, GOVT, HTR, ICB, IUSB, JHI, JMM, PAI, PCM, PLW, PTY, RCS, SAGG, SCHZ, TAI, TAPR, UBND, VBF, VBND
by: Matt Tucker, CFA

You may have noticed that your investment portfolio has been bouncing all around lately. Depending on what you own, "bouncing" may be putting it mildly. If you own only stocks, the "bounce" may feel more like a "thud". According to Bloomberg data, the S&P 500 Index - which is the leading indicator of large cap U.S. stocks - is down 9.64 percent this year, as of February 8. If you take out dividends, the price is actually closer to -9.383 percent. Ouch.

So where to turn? My colleagues Russ Koesterich and Terry Simpson talk about ways to ballast your portfolio with bonds to balance out equity risk. While I frequently discuss the importance of diversification here on the Blog, I'd like to take a deeper dive into the why and how.

Diversification Matters

It's an investor's rule of thumb and a rule of life - don't put all of your eggs in one basket. When it comes to your portfolio, it's best to spread out your holdings in markets to avoid being hit by the fall in any one investment. This is called "diversification". It works when building a portfolio of individual stocks or bonds, and works equally well when building your overall investment portfolio.

Considerations For Including Bonds In Your Portfolio

As Terry and Russ note, many investors have steered clear of the Barclays Aggregate (Agg) bond index since 2013, believing its higher duration, or interest rate risk, left them exposed to large losses in the event that interest rates skyrocketed. Well, the Federal Reserve raised its key interest rate in December from a range of 0 percent to 0.25 percent to a range of 0.25 percent to 0.5 percent. But in an unexpected twist, most interest rates have actually fallen so far this year. As a result, according to Bloomberg data, the Agg is up 2.05 percent through February 5. That's right. It's up. And while it's not enough to save you from falling equity markets, it can help cushion the blow.

Let's look at a side-by-side comparison. To illustrate our point, we looked at the S&P 500 to represent equity performance and the Agg to represent bond market performance, both YTD through February 8, 2016. The chart below shows the return numbers for a portfolio made up entirely of stocks, a portfolio made entirely of bonds and portfolios with blends of both stocks and bonds:

Click to enlarge

As you can see, the diversified portfolios have done much better in the equity market downturn, cushioning some of the stock market losses.

Now some of you may be looking at the markets and saying "Sure Matt, I get that this works when equities fall. But most people believe that equities will have higher returns than bonds over the long run. So I am going to stay in equities and just ride the market out". I hear comments like this a lot, especially from younger investors. In theory, this approach could work, but there are two big issues you may want to consider:

1. Saying you are going to ride a market out, and then actually doing it when faced with a sliding portfolio, are two very different things. There is lots of behavioral finance research that shows that investors often make bad investment decisions that are driven by emotion. You may be able to avoid this, but the data says that it is hard for most people to do.

2. You can live with a highly volatile portfolio so long as you have an infinite time horizon. But what happens when you actually need to liquidate your investment? Maybe you want to buy a car or a new home. What if your portfolio is down then? If you sell you lock in those losses. This is really the core issue with volatility: It can cause your investments to drop in value at the wrong time. A portfolio with less volatility is less likely to be significantly down at a point in the future.

And the recent market swings really bring this diversification discussion home. When the equity market is performing well, you may be giving up some gains by owning bonds, but you're also building some cushion should stock markets fall. This balanced portfolio approach helps insulate you from risk, as it is less susceptible to volatility and your portfolio value doesn't fluctuate as dramatically. This means you have a better sense of how much your investment is worth, and less uncertainty is always a good thing.

This post originally appeared on the BlackRock Blog.